How to correctly document a failed conversion

Submitted by James Peroulas on Sun, 2018-10-21 20:24

I converted from TIRA to Roth and then recharacterized back to TIRA twice in the same year (TY2016). The second conversion is a failed conversion and I received a CP2000 from the IRA asking for clarification. How do I properly document these transactions?

Specifics:
2016-02 Converted full balance of my only TIRA ($11k) to a Roth
2016-04 Recharacterized the entire balance of my only Roth to TIRA. Balance had grown to $11.9k
2016-05 Converted full balance of my only TIRA ($11,950) to a Roth
2016-06 Recharacterized the entire balance of my only Roth to TIRA. Balance was now $11.8k

I filed form 8606 with my original return and since most of the questions said “do not include amounts converted that you later recharacterized”, I didn’t include anything on that form except for the amount of the initial non-deductible contributions I made.

How should I have reported this chain of conversions and recharacterizations?



Submitted by Alan - IRA critic on Mon, 2018-10-22 00:11

  • Did the 1099R for the conversions total the two together, and the 5498 reporting the recharacterizations total those two together?   Trying to figure out what the IRS was looking at, because those two forms would not clearly identify a failed conversion, and the IRS would rarely know this occurred.
  • As for the technical consequences of a failed conversion, you would have to treat the second conversion as an excess regular TIRA contribution  (except to the extent you were eligible for a regular TIRA contribution that you did not make).  While the excess contribution was made to a Roth, it was recharacterized to a TIRA. The excess amount would incur a 6% excise tax for 2016 and 2017 to the extent the excess could not be applied as a regular TIRA 2017 contribution. This is handled on Form 5329. If you were not eligible for any regular TIRA contributions that you did not make, then you would not file Form 8606 to report any conversion because you legally recharacterized the first one, and the second one is not treated as a conversion. However, you would file Form 8606 to report any allowed non deductible TIRA contribution. The major inconsistency between this treatment and the 1099R forms that were likely issued would have to be explained with an explanatory statement with your 2016 amended return.
  • I assume that the Roth custodian was unaware that the 2nd conversion was disallowed, but the type of 1099R and 5498 forms that were issued may affect the explanation you provide.

Submitted by James Peroulas on Mon, 2018-10-22 04:24

  • I guess there are a few more specifics that were relevant 🙂 I contributed to the TIRA in 2016. All of the transactions for 2016 were as follows. My TIRA/ Roth IRA balances were both zero at the start of 2016:
  1. 2016-02 Contributed $5500 of post-tax money for a TY2015 contribution
  2. 2016-02 Contributed $5500 of post-tax money for a TY2016 contribution
  3. 2016-02 Converted full balance of my only TIRA ($11k) to a Roth
  4. 2016-04 Recharacterized the entire balance of my only Roth to TIRA. Balance had grown to $11.9k
  5. 2016-05 Converted full balance of my only TIRA ($11,950) to a Roth
  6. 2016-06 Recharacterized the entire balance of my only Roth to TIRA. Balance was now $11.8k
  • I received two 1099-R’s. The Roth 1099R’s lists the total of both recharacterizations as box 1 (distribution code N). The TIRA 1099R lists the total of both conversions in box1 (distribution code 02).
  • I also received two 5498’s (in May, after I filed my tax return). The TIRA 5498 lists the total of both recharacterizations as recharacterized contributions (box 4). The Roth 5498 lists the total of both conversions (box 3).
  • In my first response to the CP2000, I explained that this was a conversion and recharacterization that was repeated twice, but they basically sent back the same CP2000 and I’m trying to figure out what they really want. Calling the help line wasn’t helpful 🙁
  • From what I understand from your response, I have over-contributed to the TIRA and I must pay the excise tax annually until I back the money out 🙁 🙁 Oh, I think this gets even more messy. In 2017 I repeated the conversion and thus I converted TIRA funds into Roth that should have been removed from the TIRA 🙁 🙁 Oh my…

 

Submitted by Alan - IRA critic on Mon, 2018-10-22 05:01

  • Actually, disallowed reconversions are not even on the IRS radar. Almost all IRS CP2000s on non taxable conversions (back door Roths) arise from a flawed 8606 reporting the conversions, so the IRS is probably confused due to no 8606, or perhaps you did not report the non deductible contributions you converted and the IRS is looking for taxable income. But you are right, technically you did do a disallowed conversion and fixing it by the book is a real mess because the IRS will probably not understand what you are doing. It would likely end up in several correspondence cycles.  All this said, since these conversions were non taxable, it is odd that you recharacterized any of them. The second conversion if allowed would have had only $950 of taxable income if that conversions was allowed.
  • As for your listed steps, Step 1 would have required you to file Form 8606 for 2015 to report the non deductible TIRA contribution. Step also requires an 8606 for 2016 and also means that you used up your TIRA contribution space for 2016, so none of the 11,950 failed conversion could not be applied as a regular TIRA contribution. It would all be excess.
  • I would guess that between the ND contributions and the conversions, you probably did not complete the 8606 forms correctly.  Again, this is almost always the cause of back door Roth conversions CP 2000s.
  • Your last bullet point sort of compounds the problem. Did you also make a ND TIRA contribution for 2017 or a regular Roth contribution? The IRS probably has not even looked at your 2017 return yet, but could also produce an inquiry depending on what you filed vs the 1099R and 5498 forms. 
  • Note that an excess contribution has no statute of limitations for the 6% penalty, so you might abbreviate the process by simply distributing the 11,950 and paying tax on the 950. The will stop the clock from running and also eliminate the 6% excise tax for 2018.  This is not technically correct, but my fear would be that the IRS would never understand the actual failed conversion explanation and you could set of a long cycle of correspondence.

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